By Brendan Conway

Think of Bitcoin topping out at something like Mauritanian stocks or the Argentine peso, or maybe at best superceding gold and its heavily traded SPDR Gold Trust (GLD) as a kind of private, fixed-supply alternative currency.

Normand argues in a Tuesday note entitled “The Audacity of Bitcoin” that its practical use may be no greater than an emerging-markets currency with exchange controls. The key reason: What happens when transactions in the virtual world cross over to the real world. Too often, they get hung up. Or the currency turns out to be unusually costly to convert.

Mt. Gox is the most recent Bitcoin trading platform with significant difficulties when investors try to get back conventional money for the digital kind.

That’s only the start of Normand’s argument against Bitcoin giving the dollar, euro or yen a run for its money.

The view is also premised on the idea that Bitcoin is inherently inferior as a unit of account and a store of value, and that some unknown, probably significant proportion of its price volatility is a result of the very thing Bitcoin bulls applaud: the lack of a sovereign mandating its use as the official medium of exchange.

Here’s a deeper look at the argument in Normand’s own words:

What’s not to like about this system? A lot. Recall each of the three functions of money – medium of exchange, unit of account and store of value. As amedium of exchange bitcoin initially seems no better or worse than fiat currencies, since anything portable (like paper or an electronic data file) can be used as that medium so long as enough agents agree to use it. Therein lies bitcoin’s limitation: with due apology to anarchists, there is no common power like a government to compel the public to use bitcoin as universally as its own fiat currency. Recall that currencies don’t become widely used spontaneously or through a grass-roots campaign. They become widely used nationally because a government declares them legal tender,
and they become widely used internationally because they are legal tender in a significant economic area with large, unrestricted capital markets. Hence the primacy of the US dollar and euro in line with the economic significance of the US and Euro area, and the prospects for the renminbi as China pursues capital market liberalisation (chart 4). In the area of transactional demand for a currency, incumbency is an incredibly high hurdle to jump.

A virtual currency’s transactional use will always be limited unless it performs the other two functions of money better than a fiat currency. As a unit of account and store of value, bitcoin also falls well short of fiat currencies given its extreme volatility. As highlighted earlier in chart 2, bitcoin’s realised volatility has averaged 120% over the past three years, with a range of 50% to 400%. By comparison, typical G10 currency volatility is 8% with a range of 7% to 16% over the past three years. Typical emerging markets FX volatility is about 9% with a range of 7% to 20% over the past three years. Even during periods of extreme financial market stress such as the Asian Crisis of 1997/98 and the Argentine Default of 2002, currency volatility reached levels closer to 50% (Asia) or 120% (Argentina), and then only persisted for a few weeks.

True, these swings may represent simply normal volatility for a start-up currency just like the fluctuations of start-up companies’ share prices during the 1990s. Even by dot-com standards, however, these moves are brutal. The Nasdaq only quintoupled in value in three years (1997-2000), while bitcoin’s price has risen 50-fold in the past year …. Such price fluctuations make it impossible to seriously consider bitcoin as a unit of account or store of value for an material amount of corporate or investor exposure.

How much does illiquidity due to lack of fiat currency status contribute to such volatility? That is unclear, but here are a few comparative statistics. Bitcoin’s market value and turnover are trivial by currency standards. There are currently about 12mn bitcoins in circulation, which at a current price of $700 given them a value of about $8.5bn. This figure compares to currency in circulation of about $1.2trillion for US dollars, €950billion for euros and £360bn for sterling. Relative to frontier stock markets and the smallest investable bond markets, the current market value of bitcoins is similar to the market capitalisation of the Mauritian Stock Exchanges or Peruvian government bonds. Bitcoin’s average daily trading volume across major exchanges is about $20mn, compared to average daily trading volume of FX futures on the Chicago Mercantile Exchange of about $33bn for EUR, $17bn for JPY and $1.4bn for MXN (chart 7). Recall as well that over-thecounter volumes in FX are about ten times that of exchange-traded activity. Still, none of these tiny asset markets nor lowest-liquidity fiat currencies exhibits the outstanding volatility of bitcoin. Perhaps the decision to limit bitcoin supply has consequences not imagined at the time.

Ironically the lack of external oversight may prove an obstacle to significant market deepening, since many market participants would prefer the accountability of known but fallible entities to one based on a mathematical code. (Query: who does one call when there is a problem with bitcoin?). In exchange for its low-cost peer-to-peer system, bitcoin’s network contains no recourse if bitcoins are lost or hacked. At least traditional fee-charging banks provide deposit insurance and other fall-backs. With fixed supply, bitcoin’s deflationary bias should also be clear. That quality serves owners well when exchanging into foreign currency, but it would be onerous for any economy operating with it as legal tender. Indeed Weimar Germany was unpleasant, but so was the Great Depression.

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There are 6 comments

FEBRUARY 11, 2014 10:17 A.M.

Hailstorm wrote:

Volume and acceptance is less because banksters and governments are not giving it a chance. Just legalise it and see how it fares.

FEBRUARY 11, 2014 11:48 A.M.

Toby wrote:

This is FUD, plain and simple.

FEBRUARY 11, 2014 1:34 P.M.

Coin Heavy wrote:

Is the report itself available online?

FEBRUARY 12, 2014 3:33 A.M.

Where can the report be found? wrote:

Where can the report be found?

Thanks!

FEBRUARY 23, 2014 1:04 P.M.

Laureate Trust wrote:

Laureate BVI has a target of US$2500

MARCH 25, 2014 1:54 P.M.

Neal Gafter wrote:

J.P. Morgan Securities foreign-exchange strategist John Normand resorts to inventing an alternate history, which he commands the reader to accept, to explain why Bitcoin can't succeed:

“Recall that currencies don’t become widely used spontaneously or through a grassroots campaign. They become widely used nationally because a government declares them legal tender, and they become widely used internationally because they are legal tender in a significant economic area with large, unrestricted capital markets."

One can't command the reader to "recall" false premises to turn them into facts. You can read about the history of money on Wikipedia, among other places, and this theory isn't one that is found in the history books.

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